Reducing the proportion of cesses in tax collections will allow the budget to produce a bigger bang for the buck

The next budget needs to uphold the spirit of the finance commission recommendations.

Typically, about Rs 45-46 of every Rs 100 spent in the union budget goes to states in some form of the other. India is unusual in the way its powers and responsibilities are divided between the centre and states.

Globally, while states or their equivalent in different countries account for about 30% of overall government spending, in India it is 60%. However, when it comes to raising resources, the ratio is reversed. The centre raises about 63% of resources because it has complete control over direct taxes. Consequently, the pattern of sharing resources has a significant impact on the economic multiplier coming out of overall government spending.

In this context, it’s relevant that RBI staffers last year published research which concluded that the state capex multipliers are higher than the centre. Therefore, an important dimension to the efficacy of the centre’s budget is answered by the questions of where and in what forms are resources transferred to states.

Shrinking space for state finance ministers

The 14th Finance Commission chaired by former RBI governor YV Reddy recommended a large increase in unconditional transfer of resources to states. It said that 42% of taxes from the ‘divisible pool’ ought to be transferred to states. It was accepted by the centre for the period 2015-2020. The next finance commission stuck to the same trajectory of transfers.

Budget documents show that the actual transfer has trended downwards in percentage terms. From a high of a transfer to states of 37% of the centre’s gross tax revenues in 2018-19, the transfer to states had declined to 31% by 2022-23.

The effect is to shrink the space state finance ministers have in allocating money for their budget priorities. This is because even if total transfer to states from the centre’s budget since 2015 has more than doubled to Rs 18.64 lakh crore in 2022-23, the percentage of unconditional transfer has shrunk from a little over 60% to about 51%.

Role of cesses and surcharges

The shrinking fiscal space for states is on account of rising proportion of tax revenue collected by the centre in the form of cesses and surcharges. Legally, the centre doesn’t have to share cesses and surcharges. What it means is that it stays out of the ‘divisible pool’ that needs to be shared with states.

In response to a question in the Lok Sabha in March 2023, the centre put out data which showed that between 2019-20 and 2022-23, cesses and surcharges accounted for around 11-14% of the gross tax revenue it collected. What it meant is that the centre had to share less than Rs 90 of every Rs 100 it collected as taxes with states.

Expand the ‘divisible pool’

Two successive finance commissions have recommended higher unconditional transfers to states because there’s a convincing economic reason for it. To illustrate, Maharashtra and Manipur are vastly different in terms of priorities and after a point putting more resources into standardised central schemes for all states produces diminishing returns.

States are in a better position to gauge the last mile investments needed to complement central government capex.

The next budget needs to uphold the spirit of the finance commission recommendations by rolling back the extent of taxes classified as cesses and surcharges. The proportion of the divisible pool in the gross tax revenue of the centre has to increase. It will very likely produce a bigger bang for the buck.